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Monday, January 28, 2013

So your dividend got cut. Now what?

Of course a dividend cut is the worst thing an investor in dividend growth stocks can have happen. You just lost some of your future dividend income that you were expecting to be there. This is why it's best to have a margin of safety in your dividends received versus your expenses when you're planning to live off just the dividends. Assuming that you didn't see the dividend cut coming and didn't sell out of the position before hand, just how bad is it?

Well let's run through the calculations. We'll assume that you have a portfolio that provides $20,000 in annual dividends. This portfolio is invested in several companies and for the sake of making the calculations easier we'll assume that all the positions carry a 3.00% yield and are equally weighted in the portfolio. I'll run through the calculations with various position amounts. So how bad is that dividend cut?

If your portfolio consists of 10 different equal weight positions and one company announces a full dividend cut, then you just lost $2,000 in annual income. That means you now have 10% less to spend on your expenses. Well, is this really as bad as it sounds? In order to still have $20,000 in dividend income the other 9 positions would have to average an 11.11% increase in their dividend to get you back up to $20,000. That seems a little high but it's not anything that's completely impossible.

If your portfolio consists of 15 positions, your lost income is only $1,333.33 meaning you lost 6.66% of your dividends. That means the other 14 positions would need an average dividend growth rate of 7.14% to get you back to $20,000 in dividends. This is getting better and better. A 7% dividend growth rate is easily attainable from the likes of KO, JNJ, PG, CVX and the like.

Running through the calculations for a 20 and 25 position portfolio means that the remaining positions would need to increase their dividend by 5.26% and 4.17% respectively. This is very comforting knowing that should a dividend cut happen a 20 to 25 position portfolio can easily overcome the loss of dividends within 1 year. I try to invest in companies that I feel have extremely large moats that I shouldn't have to worry about the possibility of a dividend cut. However, I do own some smaller companies that a dividend cut could potentially happen at some point in the future if growth happens to stall.

And even better news, is this assumes that you not only didn't see the potential dividend cut coming but also lost all of the capital. In reality most companies, save the Enron's/Worldcom's, don't go bankrupt overnight with no foreshadowing of any underlying issues to the company. So even if a company does announce a dividend cut, 99.99% of the time you can still sell out of your position if you're worried about the sustainability of the company and recoup some of your capital to help make up for the lost income. This would further reduce the required growth rate from the rest of your portfolio to pick up the slack.

I'm not saying that I would welcome a dividend cut, but sometimes running through the numbers will help shed light on just how much damage or little damage it might cause.

It's not completely right, because the position sizes and yields aren't going to all be equal across an entire portfolio but it's about as good as can be done. I was mainly looking to give a general overview of what would potentially happen should a company you own cut its dividend.

I strongly recommend a good sized emergency fund, especially if you're planning to live off just the dividends. I've been going back and forth on whether I should have 1 or 2 years cash saved up but I've still got plenty of time to decide on that. Either way an emergency fund is necessary for situations like this and other unexpected major expenses.

I know that many dividend investors, particularly dividend growth investors, are adamant that if the dividend is cut, or in fact even if it is not increased in a given year, they will sell the stock. Although I understand the thinking behind the strategy, my approach is not so black and white. In fact, in 2012 I bought two securities (Viola Environnement and Telefonica) after they had announced dividend cuts. I know this goes against the practices of many (if not almost all) dividend investors, but my thinking was that both still continued to have healthy yields after the cuts, and both had previously been dividend growth companies. My hope/expectation was that both would return to that status once the situation in Europe settled. In the interim, I collect a healthy dividend. Just my approach.

I think if a company cuts its dividend or it's looking like it probably will it's fairly prudent to get out ahead of the announcement or very soon after because the price is going to drop hard and fast. But I wouldn't completely stay away from a company just because of that if I thought their future prospects were still solid. Of course, they wouldn't have cut the dividend if everything was rosy so you definitely need to do more homework to see what's going on.

Telefonica is a prime example of one that will probably continue along on its dividend increasing ways once Europe gets back on track. I haven't looked at Veolia before but just heard it in passing. Guess I'll have to check on it some more.

The 10 and 15 scenarios are pretty scary. There is no guarantee your portfolio will be able to make the lost ground over the course of a year. There are DGR disappoints from time to time (think PEP and EMR last year). Not only that but inflation isn't going to stop just because a stock cut its dividend.

I would not be comfortable at all with a concentrated portfolio, especially if it was my main source of income. Scary stuff. 30-50 positions is right for me.

The 10 is definitely worrisome, but it's nice to see just how low of a DG you need the rest of your positions to average if you get up to 20+ positions. I think this goes to show how important diversification is if you're planning to live or get a majority of your retirement income from DG stocks. I plan on having a minimum of 20 positions when I reach FI and finally call it quits from a traditional 9-5 til 65 job. Most likely closer to 40-50.

A dividend raise by 24 out of 25 companies sure can make a difference, can't it?

This exercise simply illustrates why I like a portfolio of at least 30 stocks. Not only is that diversification in the traditional sense, as one tries to reduce risk by spreading out across sectors and businesses, but for me it's all about "income diversification". I simply want to know that when I'm FI I'll still be able to pay rent and eat if a company or two performs unexpectedly. In a heavily concentrated portfolio a cut or two can dramatically affect one's lifestyle if you're living off dividend income. Of course even then, one should be diversified in other asset classes...but if your dividend stock portfolio makes up a large part of your assets (as in my case) you would be hurtin'.

This definitely shows just how important income diversification is. I'd hate to be trying to live off my dividends and have a situation where one of them cut the dividend but my portfolio was too concentrated that I have to then find a way to make up the lost income. You bring up a good point about asset class. My main hope is to either have a pretty ridiculous margin of safety between expenses and dividend income or at least one rental property. Bonds aren't appealing to me at all right now but when the yields eventually rise I'll start adding some. I'd much rather be invested in individual bonds because that way you're not at the mercy of all the other investors with mutual funds should rates move higher.

Nice examples. They show that really isn't that bad when you suffer a dividend cut so thanks for posting it.However, I am not sure if that 11% includes your replacement or not. I assume that if you suffer a cut from 3% current yield, let's say a complete dividend cease, you would sell the company, take some capital loss and immediately buy another company paying 3%, so the only loss in dividend payout would be that you would be able to buy less shares due to previous capital loss (assuming all prices are constant and you are buying the new shares for the same price as the original stock), then the result is actually even better, right?

You're right. Theres no way of telling how much of a loss you would take so I just assumed that capital was no longer available. Since you would actually have some capital you could then invest the, situation just gets better.

I totally agree. If I think there might be a cut coming then I'll at least trim back the position if not close it outright. But it's nice to see that if you didn't make any moves before hand and the dividend was cut, that the damage is still manageable if you have a 20-25 position portfolio.

There's way too many assumptions to cover all bases. One major one in this example is that all the positions are equally weighted and have a 3.00% yield and therefore contribute equally to the dividend income. Unless that is your specific goal that's not a very likely outcome for a portfolio.

More than trying to make up the cut with dividend growth elsewhere, I would want to understand what a dividend cut means for the moat of the company. Companies are typically loathed to cut dividends, so this may indicate some underlying problems (which is why most dividend investors bail when dividends are cut).

I am comfortable with no increases in dividends if the companies financials are sounds and the payout ratio is otherwise in range, but a dividend cut makes me nervous. As you suggest, no reason to panic, but calls for a close evaluation of why the company cut.

I totally agree that it's best to find out why the dividend was cut. If for nothing else, you can learn from it to see potential trouble spots with other investments. But it is a little comforting knowing that with a diversified portfolio you won't be completely sunk.

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